Replacing TFSA money too early will cost you

The tax-free savings account (TFSA) has become a very, very popular savings vehicle for Canadian taxpayers with over 10 million accounts open at the end of 2013.

As you know, there is no tax deduction or immediate benefit for putting money into a TFSA. However, any investment income (interest, dividends and capital gains) earned within the TFSA is tax-free. This has saved taxpayers over $1 billion since 2009, says CRA.

As well, all withdrawals are tax- free. These characteristics make the TFSA an ideal shelter for long-term retirement savings, as the future withdrawals have no negative effect on taxes, income-tested tax credits or other social benefits.

However, TFSAs are not without potential costs imposed by CRA, as we were reminded last week when CRA announced 54,700 taxpayers received warnings they may face penalties for TFSA over-contributions.

Failure to respond to these letters within 60 days results in a Notice of Assessment and a tax of one per cent per month of the amounts deemed in excess of your current contribution limit is imposed.

More than 20,000 taxpayers have already paid penalties for the 2013 tax year. The tax is on the highest excess amount in any given month, and continues until rectified.

The problem often arises when people use the TFSA as a short-term savings vehicle. There's nothing wrong with that; it is perfectly legitimate. Withdrawals can be made at any time without tax, and the amount withdrawn can be re-deposited in the next tax year without penalty.

The key there, of course, is the next tax year. This appears to be a tough concept for some people, as CRA says 11,260 taxpayers received the same warning from them two years in a row.

Another cause of penalties is the transfer of TFSA monies from one financial institution to another. Such transfers are allowed, as long as the transfer is done directly between institutions and the relinquishing institution files the proper paperwork with CRA.

Unfortunately, many taxpayers over the last few years have moved their TFSA by manually withdrawing from one institution, and then depositing again at institution two. Result -- penalty for over-contribution.

Here's how it works.

Since 2009, every taxpayer aged 18 or over has been entitled to a make TFSA contribution, with an annual limit. Any current year, the unused contribution amount carries forward and is added to the limit for the next year.

The annual limit for 2009 through 2012 was $5,000 (total $20,000) and increased to $5,500 for each of 2013 and 2014. Therefore, a person who was 18 in 2009 has been able to contribute $31,000, including the 2014 deposit. That's the person's cumulative contribution limit.

Tax-free withdrawals are allowed at any time. The amount of any withdrawal is added back to your cumulative contribution limit the next Jan. 1. For example, if you withdraw all $31,000 in 2014, you can deposit it in 2015, plus your new 2015 limit of $5,500.

However, and this is where the penalties become imposed, that 2014 withdrawal cannot be re-deposited in 2014.

With growth, the TFSA could be worth well over $31,000, and we have clients with TFSA balances in excess of $50,000. You can withdraw your growth tax-free at any time, and re-deposit it in a later year.

So, the simple rule is: don't replace any TFSA withdrawals until next year, unless you know you are still under your cumulative contribution limit, and only deposit up to that limit.

As with power tools, boats and fireworks, play safe with your TFSA.

* * *

A quick congratulation to the organizers and participants of the 49th LOWISA, the largest international freshwater sailing regatta in the world, held annually at Lake of the Woods. Special thanks to the American crews who trucked their boats up to compete, and kudos to Commodore Bob Webb for a great success. After seven days of racing, the overall title was won by 12 seconds, with the crew of Borderline edging out RhumbLine at the finish line.

David Christianson, BA, CFP, R.F.P., TEP, CIM is a financial planner and adviser with Christianson Wealth Advisors, a vice-president with National Bank Financial Wealth Management and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.

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